The Gnomes of Santa Fe

By John Rothchild

Published: November 7, 1999

THE PREDICTORS

By Thomas A. Bass.

309 pp. New York:

Henry Holt & Company. $25.

THOMAS A. BASS has written an engaging account of the short life (so far) of the Prediction Company, owned and operated by maverick physicists in rafting sandals and T-shirts, who baby-sit a computer in Santa Fe, N.M. The computer is programmed to make serious financial bets, with cash provided by a large and once stodgy Swiss bank. That bankers in pinstripes and wingtips have risked sizable sums on this quirky enterprise in the desert says a lot about what's happening on the frontier of finance.

The central characters, Doyne Farmer and Norman Packard, abandoned comfortable jobs (Packard at a university, Farmer at a research lab) to start Prediction in 1991. Both in their 40's, they had few personal assets to draw on. Packard had never owned a house or a new car. Before they could incorporate, they held agonized discussions with the staff about the morality of capitalism. At one strategy session, Packard remarked, ''Talking about cash flow, how are we going to pay for our sandwiches?''

They knew next to nothing about the stock and bond markets, but they knew a great deal about chaos theory. Part of an avant-garde of physicists called the Chaos Cabal, Farmer and Packard had studied the helter-skelter of cascading rapids, falling snowflakes, measles epidemics -- even Italian politics. Where traditional scientists saw random turbulence, beyond the scope of ''linear'' Newtonian analysis, the Chaos Cabal saw intriguing patterns. They could stick a probe into running water at the top end of a pipe and predict the spatter of droplets and spume farther down.

This was interesting to hydraulic engineers, but it wasn't making anybody rich. Then sometime in the mid-1980's, when computers had linked banks, trading floors and investment houses on six continents, and billions of dollars sloshed through cyberspace around the clock, it occurred to Farmer that money flow was a lot like fluid flow. If he and Packard could find patterns in running water, why couldn't they find patterns in the crests, eddies and sinkholes of the Dow Jones industrials, Treasury bonds or Japanese yen? Eureka!

Bass, the author of several books, including ''The Eudaemonic Pie'' (about Farmer and Packard's scheme to beat the odds in Las Vegas), takes a cue from his subjects and tells the story in nonlinear fashion. With frequent and informative digressions, he moves back and forth from Prediction headquarters to the trading pits of Chicago to recent and ancient attempts to foretell the future ups and downs of markets. Isaac Newton himself, who lost much of his wealth in the London crash of 1720, lamented the inability of his beloved science to predict it. ''I can calculate the motion of heavenly bodies, but not the madness of crowds.''

Bass takes us forward again to three meetings held in Santa Fe in the late 1980's, where chaos physicists and traditional economists debated theories. The physicists chided the economists for continuing to rely on shopworn Newtonian concepts, the source of rotten forecasting of financial turbulence for nearly three centuries. Farmer gave a speech at the first gathering that intrigued the Citicorp chief executive, John Reed, who was in attendance. Reed's bank was choking on sour third-world loans, and his well-paid economists hadn't warned of this deadbeat debacle.

A long middle stretch of the narrative is devoted to the physicists' search for a partner with a bankroll. Though Reed's Citicorp is an obvious choice, Farmer and Packard decide to knock on other doors. They get serious interest, if not outright offers, from the Bank of America, PaineWebber, Salomon Brothers, Merrill Lynch, Goldman, Sachs and Morgan Stanley. Meanwhile, back at Prediction headquarters, the staff tweaks and twiddles the computer, force-feeding it endless bytes of data, hoping it will regurgitate a betting system that wins. So far, it has made brilliant mock trades in various anachronistic simulations, but as soon as it starts trading in the present, it loses.

A lot of commentators have said Wall Street is like a casino, but ''The Predictors'' is the best description yet of how futures, options and more esoteric derivatives have turned world finance into a casino. Moreover, the financial casino is attracting the same players who tried to outsmart Las Vegas 25 years ago. Back then, Farmer and Packard stuffed tiny computers into their shoes and began a high-tech attack on the blackjack tables and roulette wheels. Glitches undid them, and they returned to salaried employment. Now, in their search for a bankroll, they reconnect with cronies from the ''beat the dealer'' days who manage billion-dollar hedge funds. They end up in a partnership with a Chicago trading house, O'Connor & Associates. The boss there, David Weinberger, had earlier used chaos theory to bet on football.

In 1992, as the Prediction Company is absorbed into O'Connor, O'Connor is absorbed into the Swiss Bank Corporation. Conservative bankers are caught up in the casino along with everybody else: betting on blips can be more profitable than banking. Weinberger's minions at O'Connor, mostly 20-something traders, take over top positions in the firm that just bought them, and within a year they've helped turn Swiss Bank into one of the top players in derivatives worldwide. Soon thereafter, Swiss Bank swallows the Union Bank of Switzerland, that nation's largest. Union has got in trouble, proving that betting on blips can also be more dangerous than banking.

At this point, Prediction's computer is making big bets with the Swiss bankers' money. On the most important point -- results -- Bass is ambiguous. After his exciting buildup, we want to know how much the chaos system has won or lost, and whether it is doing better or worse than George Soros, the Dow Jones industrials or the dartboard. All we learn is that it went on a losing streak and then a hot streak, and that after 1995 it met its quarterly objectives. We never find out what those objectives were. Since Bass got full access to almost everything (he's on the scene through countless meetings, getting long quotations, describing what the physicists think and feel and eat for lunch), perhaps he had to agree in advance not to reveal the bottom line. No matter. I suspect that if the Prediction people have found what Bass calls the holy grail of market forecasting, we'll see Farmer and Packard on the Forbes magazine list of richest Americans. So far, they haven't appeared there.

John Rothchild, the author of ''A Fool and His Money,'' writes frequently on financial matters.